Stockwatch: Lock in high yield before this share rises

Shares in Fenner, the manufacturer of conveyor belts, hoses and seals, have slumped to about 200p from a 300p-500p trading range in recent years, as deflation has slowed the mining industry. Fenner's "reinforced polymer technology" is applied for conveyor belting, hoses and seals in a variety of industries although mining tends to characterise its trading updates.

Fears this downturn could persist mean Fenner is priced to yield 5.75% covered about 1.6 times by earnings, assuming the company's latest guidance is fair. Such a scenario need only be roughly realistic for the stock to re-rate - over time - in order to price the dividend more competitively. Assuming it is held at 12p a share, a yield say of 4% implies a share price of about 300p i.e. some 50% upside. Implicitly the market is cautious that commodities’ deflation will reduce mining and other industrial activity for quite some time, leading to a dividend cut. It's possible to analyse a lot of detail about this business, but I’d cut to the chase with "Occum's razor", i.e. the approach with fewest assumptions. If the dividend is fairly secure, this stock must eventually rise.

Directors actually bought at higher prices

When prelims to end-August 2014 were announced early last November, management said it was not seeing any significant change in trading conditions or the competitive landscape; however, sentiment in the US coal industry remained fragile and Australia sounded increasingly tough. Offsetting this somewhat were better prospects in South America, China and the Middle East, although the Ebola outbreak had cast a cloud over West Africa. Operationally, while some segments of the group offered growth prospects they were likely to be offset by weakness in the mining market.

As if believing the shares were already too cheap for this scenario, four directors promptly bought a total £130,450 worth at prices from 295p down to 250p, the keenest buyer being the chief executive who made an initial purchase of 13,000 shares at 295p.

The best that can be said is this shows directors are not necessarily astute in the stockmarket. Of more concern is whether Fenner's industries offer little by way of visibility: the market is liable to price any stock for a generous yield to compensate for this risk, once perceived.

Strong dividend profile despite modest downgrade

A 14 January AGM trading update then said the earnings outlook for the financial year to end-August 2015 would be "slightly below our previous expectations", hence a consensus now for about £55 million pre-tax profit this year (see table). Mind this will be "pre-exceptionals" as the update also cautioned of a charge for implementing cost savings; otherwise, it implies a price/earnings (PE) multiple of about 11 times.

The dividend should be able to weather this scenario unless trading deteriorates significantly further. The 2013/14 cash flow statement showed a total £24.2 million paid in dividends (including to non-controlling interests) in context of £68.6 million net cash from operations - i.e. after deducting tax, working capital changes, deferred considerations on acquisitions and pension contributions; then adding back charges for depreciation and impairment of intangibles. So the company may be able to withstand quite some drop in profit before a decision to re-base the dividend becomes prudent.

The 2008/09 year (following the financial crisis) is useful for context: the total dividend per share was held at 6.6p as underlying earnings per share fell from 17.7p to 12.8p (basic EPS as low as 2.6p). The year to end-August 2010 then saw normalised EPS recover to 17.9p with DPS growth to 7.2p. The table shows the dividend growing with earnings cover of 2-3 times and generally strong cash flow. Obviously, now DPS has reached 12p its cover drops in the current scenario, although the board has seemingly balanced shareholder distributions versus investment etc. Arguably a 5%+ yield is fair compensation for the economic risks, hence rational the share price is off a 197p low in response to the 14 January update.

Cautious investors may feel the company has effectively lagged expectations for about a year now, and needs to show more evidence it has at least stemmed downturn. Enterprising long-term investors will find such sentiment useful to accumulate stock.

Balance sheet is good in parts if quite highly geared

Besides visibility, another reason for the market’s wariness is £178.6 million longer-term debt also £34.6 million short-term, for gearing of 63% assuming net assets of £336.2 million. Mind this figure includes £212.5 million intangible assets. The "current ratio" of short-term assets against liabilities was 1.7 times at end-August and there was cash of £95.9 million, so Fenner has no major balance sheet risk. If its downturn proves chronic, however, note that the £15.6 million net cost of debt in the last financial year took 35% of operating profit. It's hardly surprising the market prices the stock for additional yield to compensate for this risk. In a "risk-off" environment like we saw in markets last December, this factor may have accentuated selling, but if sentiment settles then enterprising investors will brush aside modest debt worries.

America has been an irony

At 46% of revenue the Americas are Fenner's biggest market and the sense is the US economy in particular, now booming. Yet revenue has decreased by 18% as sentiment in the coal industry was hit both by low prices in export markets and uncertainty over US government policy towards the coal industry. Miners were inclined to run belts closer to the point of failure. The latest update cited American demand as stable albeit at low levels. The situation shows how the wider deflationary theme is affecting even the US economic success story.

So the stance significantly depends on your risk appetite: further crisis for global demand could see a bit more downside although Fenner's financial profile implies the share price will eventually rise from about 200p. A 12p a share dividend is amply possible for this business, so you can also lock in a useful yield.

For more information see fenner.com/en/home.